PLR 1046011: S corporation election restored after inadvertent passive-income termination

Plain-English summary

The IRS ruled that a corporation's S corporation election terminated because it had accumulated earnings and profits and passive investment income exceeding 25% of gross receipts for three consecutive tax years. The IRS also determined that the termination was inadvertent under section 1362(f). The corporation and its shareholders had filed returns consistent with S corporation treatment, distributed the accumulated earnings and profits, and agreed to make any required adjustments. The corporation could therefore continue to be treated as an S corporation beginning on the redacted termination date, unless another termination applied. The ruling required a payment to the IRS within 45 days and stated that the ruling would be void if that condition was not met.

Ruling snapshot

• Question: Could the corporation receive relief from an inadvertent termination of its S corporation election caused by excessive passive investment income?
• Outcome: Approved
• Key authorities: IRC §§ 1361(a)(1), 1362(a), 1362(d)(3)(A), and 1362(f); Treas. Reg. § 1.1362-4(b)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201046011 Third Party Communication: None
Release Date: 11/19/2010 Date of Communication: Not Applicable
Index Numbers: 1362.00-00, 1362.02-00,
1362.02-03, 1362.04-00 Person To Contact:
----------------------, ID No. -------------
------------------------------- Telephone Number:
------------------------ ---------------------
--------------------------------- Refer Reply To:
-------------------------------- CC:PSI:B03
PLR-108352-10
Date:
September 02, 2010

                                               LEGEND

X = -----------------------------------------------------------------------------------------------------
-----------------------

State = ----------

A = -----------------------------------------------------------------------------------------------------
-------------------------

B = -----------------------------------------------------------------------------------------------------
-------------------------

C = -----------------------------------------------------------------------------------------------------
-------------------------

D = -----------------------------------------------------------------------------------------------------
-------------------------

Date = -------------------
1
Date = -----------------
2
Date = ------------------
3
Date = ------------------
4

Date = ------------------
5
Date = ------------------
PLR-108352-10 2

6
Date = ------------------
7
Date = -----------------
8
a = -------------

b = --------------

Dear -------------:

   This letter responds to a letter dated February 15, 2010, and subsequent

correspondence, submitted on behalf of X by X’s authorized representatives, requesting
a ruling under § 1362(f) of the Internal Revenue Code.

                                     FACTS

   According to the information submitted, X was incorporated under the laws of

State on Date 1. X elected to be an S corporation effective Date 2. In the consecutive
taxable years ending Date 3, Date 4, and Date 5, X received passive investment income
(within the meaning of § 1362(d)(3)) in excess of 25% of its gross receipts.
Furthermore, X had accumulated earnings and profits (AE&P) remaining in each of
these three years. To correct the error, X elected to distribute all of its AE&P in the
amount of $a to A, B, C, and D on Date 6 pursuant to § 1.1368-1(f)(3) of the Income
Tax Regulations. On Date 7, X discovered that its S corporation election had
inadvertently terminated on Date 8. X requested this ruling soon after discovering that
its S corporation election had terminated.

   X represents that the circumstances resulting in the termination of X’s S

corporation election were inadvertent and were not motivated by tax avoidance or
retroactive tax planning. X further represents that X and X’s shareholders have filed tax
returns consistent with X being an S corporation. X and its shareholders agree to make
any adjustments consistent with the treatment of X as an S corporation as may be
required by the Secretary with respect to the period specified by § 1362(f).

                             LAW AND ANALYSIS

      Section 1361(a)(1) provides that the term "S corporation" means, with respect

to any taxable year, a small business corporation for which an election under § 1362(a)
is in effect for such year.

   Section 1362(d)(3)(A)(i) provides that an election under § 1362(a) shall be

terminated whenever the corporation has accumulated earnings and profits at the close
of each of three consecutive taxable years, and has gross receipts for each of the
taxable years more than 25% of which are passive investment income. The termination
PLR-108352-10 3

is effective on and after the first date of the first tax year beginning after the third
consecutive taxable year referred to in § 1362(d)(3)(A)(i).

   Section 1362(f) provides that if (1) an election under § 1362(a) by any

corporation was not effective for the taxable year for which made (determined without
regard to § 1362(b)(2)) by reason of a failure to meet the requirements of § 1361(b) or
to obtain shareholder consents or was terminated under § 1362(d)(2) or (3), (2) the
Secretary determines that the circumstances resulting in such ineffectiveness or
termination were inadvertent, (3) no later than a reasonable period of time after
discovery of the circumstances resulting in such ineffectiveness or termination, steps
were taken so that the corporation for which the election was made or the termination
occurred is a small business corporation, or to acquire the required shareholder
consents, and (4) the corporation for which the election was made or the termination
occurred, and each person who was a shareholder in such corporation at any time
during the period specified pursuant to 1362(f), agrees to make such adjustments
(consistent with the treatment of such corporation as an S corporation) as may be
required by the Secretary with respect to such period, then, notwithstanding the
circumstances resulting in such ineffectiveness or termination, such corporation shall be
treated as an S corporation during the period specified by the Secretary.

    Section 1.1362-4(b) provides that for purposes of § 1.1362-4(a), the

determination of whether a termination or invalid election was inadvertent is made by
the Commissioner. The corporation has the burden of establishing that under the
relevant facts and circumstances the Commissioner should determine that the
termination or invalid election was inadvertent. The fact that the terminating event or
invalidity of the election was not reasonably within the control of the corporation and, in
the case of a termination, was not part of a plan to terminate the election, or the fact that
the terminating event or circumstance took place without the knowledge of the
corporation, notwithstanding its due diligence to safeguard itself against such an event
or circumstance, tends to establish that the termination or invalidity of the election was
inadvertent.

                                    CONCLUSION

    Based solely on the representations made and the information submitted, we

conclude that X's S corporation election terminated on Date 8, under § 1362(d)(3)(A),
because X had AE&P at the close of each of three consecutive tax years ending on
Date 5, and had gross receipts for each of those years more than 25% of which were
passive investment income. We further conclude that the termination was inadvertent
within the meaning of § 1362(f). Pursuant to the provisions of § 1362(f), X will be
treated as continuing to be an S corporation beginning on Date 8 and thereafter, unless
X’s S election is otherwise terminated under § 1362(d). X must send payment of $b
with a copy of this letter to the following address:

                              Internal Revenue Service

PLR-108352-10 4

                             Cincinnati Service Center
                            201 West Rivercenter Blvd.
                               Covington, KY 41011
                                     Stop 31
                                   Terri Lackey
                                 Manual Deposit.

X must send this payment no later than 45 days from the date of this letter. If this
condition is not met, then this ruling is null and void. Furthermore, if this condition is not
met, X must send notification that its S election has terminated to the service center with
which X’s S election was filed.

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. Specifically, we express or imply no opinion concerning
whether X’s S corporation election was a valid election under § 1362.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.

  In accordance with a power of attorney on file with this office, we are sending a

copy of this letter to your authorized representatives.

   The ruling contained in this letter is based upon information and representations

submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for the ruling, it is subject to verification on examination.

                                   Sincerely,

                                   /s/

                                   James A. Quinn
                                   Senior Counsel, Branch 3
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

Enclosures (2):

   Copy of this letter
   Copy for § 6110 purposes

cc: